The risk-free rate over the last five years was 1% per year. The market return a

Question

The risk-free rate over the last five years was 1% per year. The market return averaged 13% per year with a standard deviation of 20%. The Copper Fund had an alpha of 2.5% per year with a beta of 0.7 while the Gold Fund had an alpha of 3.6% with a beta of 1.4. The Sharpe ratios of the two funds were 0.48 and 0.39 respectively. Investors hold these mutual funds in conjunction with others to create a well diversified portfolio of risky securities.

Is it valid to conclude that Gold Fund performed better because it had a higher alpha? Why or why not? Calculate appropriate performance metric to find the fund that performed better.

Explanation / Answer

Alpha & beta both are the measure of risk. However, an investor would prefer an investment with high alpha and low beta. This is because high beta means high volatility and huge risk.

Sharpe's ratio is the measurev of risk and return. So lower the sharpes ratio better the investment.

Therefore, it is valid to conclude that investment in gold fund is better as it has high alpha and low sharpe's ratio.

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